INTERNATIOANAL FINANCE

INTERNATIOANAL FINANCE

Exchange Rates and the Foreign

Exchange Market :

CHAPTER 13

An Asset Approach

Relative ConceptsExchange rate:

the price of one currency in terms of another

Direct quote:

Indirect quote:

Unit currency Direct quote

Indirect quote

the price of one unit foreign currency in terms of domestic currency

the price of one unit domestic currency in terms of foreign currency

Pricing currency

domestic currency foreign currency

foreign currency domestic currency

Quotations

直接标价法间接标价法

汇率

Examples Direct Quotation

In Shanghai USD100=CHY810.565

In Frankfort USD1=EUR0.8245

Indirect Quotation

In London

In New York USD1=EUR0.8245

GBP1=USD1.7575

美元 人民币

欧元

英镑

Depreciation and Appreciation

All else equal, a All else equal, a depreciationdepreciation of a country’s of a country’s

currency makes its goods cheaper for foreigners.currency makes its goods cheaper for foreigners.

All else equal, a All else equal, a appreciationappreciation of a country’s of a country’s

currency makes its goods dearer for foreigners.currency makes its goods dearer for foreigners.___________

___________贬值 与 升值

Foreign Exchange Market

Defination:Defination:

currencies are traded.currencies are traded.

the market in which internationalthe market in which international

Major actors of the FX market:

• Central banks• Nonbank financial institutions

• Commercial bank • Corporations

外 汇 市 场

Framework of the Market (I)Central bank

selling foreign

currency

buying foreign

currency

Corporations (importors & exporters)

Nonbank financial institutions Other users (eg.international tourists )

A ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· N

Commercial

banks --

------

---------

----

-

--------------

Buying foreign currency with

domestic currency

Buying domestic currency with

foreign currency

Corporations(importors & exporters)

Nonbank financial institutions

Central bank

A ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· ··· N

Other users (eg.international tourists )

Commercial

banks --

------

----

----

Framework of the Market (II)

---- ----

or Retail market

or Wholesale

market

commercial trading

Intervenient trading

Over-the-counter market

柜台交易市场

Interbank market

银行间市场

LondonNew York Paris Frankfort Shanghai Tokyo

SydneyHongkongSingapore

Framework of FX market (III)

What’s you spot USD JPY,

pls ?

140.20/30

Buy USD1( million )

OK, done.

Characteristics of the Market• Foreign exchange trading takes place in many financial centres.

• These major forex trading centres forms a round-o’clock market as they are linked by direct phones, fax and internet.

arbitrage

• Most FX deals between banks involve exchanges of nondollar currencies for U.S. dollars. examples a vehical currency

Spot Rates & Forward Rates即期汇率与远期汇率

Spot Exchange Rates: Spot Exchange Rates: Exchange rates governing such “on-the-Exchange rates governing such “on-the-

spot” trading. (two days after a deal is spot” trading. (two days after a deal is struck)struck)

Forward Exchange Rates: Forward Exchange Rates: Exchange rates deals sometimes specify a Exchange rates deals sometimes specify a

value date farther away than 2days-- value date farther away than 2days-- 30days , 90days,180days,or even several 30days , 90days,180days,or even several years. years.

Foreign Exchange Swaps

Foreign Exchange Swaps: Foreign Exchange Swaps: a spot sale of a currency combined with a a spot sale of a currency combined with a

forward repurchase of the currencyforward repurchase of the currency

Currency Futures

Futures:Futures: a future contract means a promise that a a future contract means a promise that a

specified amount of foreign currency will specified amount of foreign currency will be delivered on a specified date in the be delivered on a specified date in the futurefuture

Currency Options

Options:Options: gives its owner the right to buy or sell a gives its owner the right to buy or sell a

specified amount of foreign currency at a specified amount of foreign currency at a specified price at a specified expiration specified price at a specified expiration datedate

Demand for Foreign Currency Assets Asset & Asset ReturnsAsset & Asset Returns Interest RatesInterest Rates Exchange Rates & Asset ReturnsExchange Rates & Asset Returns A Simple RuleA Simple Rule Return, Risk, and Liquidity in the Foreign Return, Risk, and Liquidity in the Foreign

Exchange MarketExchange Market

Exchange Rate & Asset Returns

Rate of return: The percentage increase in Rate of return: The percentage increase in value it offers over some period.value it offers over some period.

Invest 100$ to buy a share of stock and the Invest 100$ to buy a share of stock and the dividend is 1$.dividend is 1$.

If the price rise to 109 $ or drop to 89 $.If the price rise to 109 $ or drop to 89 $. (109 +1)/100 –1 = 10%(109 +1)/100 –1 = 10% (89 + 1)/100 –1 = – 10%(89 + 1)/100 –1 = – 10% Expected rate of return (P.334)Expected rate of return (P.334)

Equilibrium in the FX MarketInterest ParityInterest Parity

The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return.

利息平价: The basic: The basic equilibrium condition equilibrium condition

€ • E$/€ = $

€ • (1+R€ ) = €f

Asset Market Linkages

$

€

E$/€

$f

Ee$/€

€f

(1+R$ )

(1+R€ )

Spot FX market

Future spot FX market

Euro money market

dollar money market $ • (1+R$ ) = $f

$f / Ee$/€ = €f

e.g. E$/€ = 1.2, €1000000= $ ?€1000000×1.2= $ 1200000e.g. Ee

$/€ =1.245, $f 132000= €f?

$f 132000/1.245= €f10 6000

e.g.R$ =10%, $1200000=$f ?

$1200000×(1+10%)=$f 1320000

e.g.R€ = 6%, € 1000000= €f ?

€ 1000000×(1+ 6%)= €f10 60000

€• E$/€ •(1+ R$)/ Ee$/€ = € • (1+ R€)

1000000×1.2×(1+10%)/1.245=1000000×(1+ 6%)

• (1+R$ )€ • E$/€ € • (1+R€ )

E$/€ +E$/€ • R$ = Ee$/€ +Ee

$/€ • R€

Ee$/€ -E$/€ =E$/€ • R$ -E

e$/€ • R€ (Ee

$/€ -E$/€ )/ E$/€ =R$ -Ee$/€ • R€ / E$/€ (Ee

$/€ -E$/€ )/E$/€=R$-R€-(Ee$/€ -E$/€ )/E$/€• R€

∴ (Ee$/€ -E$/€ )/ E$/€ = R$ -R€ or

∵ (Ee$/€ -E$/€ )/ E$/€ • R€ is a small number

R$ = R€ +(Ee$/€ -E$/€ )/ E$/€ ( interest parity condition )

/Ee$/€ =

E$/€ = Ee$/€ (1+ R€ )/(1+R$)

Interest Parity Condition

(Ee$/€ -E$/€ )/ E$/€ = R$ -R€

or

R$ = R€ +(Ee$/€ -E$/€ )/ E$/€

• The change in the expected future exchange rate is roughly equal to the difference between the two interest rates.

• The expected rate of return on one asset must equal that of the other asset when measured in the same currency.

________________

$

€

E$/€

$f

Ee$/€

€f

(1+R$ )

(1+R€ )

E$/€ (1+R$ ) / Ee$/€ = (1+R€ )

利息平价条件Derivation of Interest Parity Condition

远期汇率与抵补的利息平价

● ● The currency with a higher interest rate sells at a The currency with a higher interest rate sells at a discount in the forward exchange market.discount in the forward exchange market.

• The currency with a lowerer interest rate sells at a premium in the forward exchange market.

• (1+R$ )€ • E$/€ € • (1+R€ ) E$/€ +E$/€ • R$ = Ef

$/€ +Ef$/€ • R€

Ef$/€ -E$/€ =E$/€ • R$ -E

f$/€ • R€ (Ef

$/€ -E$/€ )/ E$/€ =R$ -Ef$/€ • R€ / E$/€ (Ef

$/€ -E$/€ )/E$/€=R$-R€-(Ef$/€ -E$/€ )/E$/€• R€

∴ (Ef$/€ -E$/€ )/ E$/€ = R$ -R€ or

∵ (Ef$/€ -E$/€ )/ E$/€ • R€ is a small number

R$ = R€ +(Ef$/€ -E$/€ )/ E$/€ ( covered interest parity )

Forward Exchange Rates & Covered Interest Parity

/Ef$/€ =

________________

$

€

E$/€

$f

Ee$/€

€f

(1+R$ )

(1+R€ )

Let Ee$/€ =Ef

$/€ , expected future FX market is seen as forward FX market./ Ef

$/€ = (1+R€ ) E$/€ (1+R$ )

Ef$/€ =E$/€ • (1+ R$ )/(1+R€ )

Covered Interest Parity

(Ef$/€ -E$/€ )/ E$/€ = R$ -R€

or

R$ = R€ +(Ef$/€ -E$/€ )/ E$/€

(Ef$/€ -E$/€ )/ E$/€ = R$ - R€

Let P stand for

升水, then P = R$ – R€ .

, then D = – P = R€ – R$ .贴水

Let D stand for

premium

discount

If R$ > R € , then Ef $/€

> E $/€ ;

If R$ = R € , then Ef $/€ = E $/€ ;

If R$ < R € , then Ef $/€ < E $/€ .

Ef$/€

How changes in E affect expected returns (I)

R$= R€ + (Ee$/€- E$/€)/ E$/€ R€ + (Ee

$/€/ E$/€ -1)

R$> R€ + (Ee$/€- E$/€)/ E$/€

capital inflow

E$/€

R$= R€ + (Ee$/€- E$/€)/ E$/€

Expected dollar return

Expected dollar return on euro deposits

current depreciation

Dollar appreciates.

Interest parity condition holds again.

How changes in E affect expected returns (II)

R$

Other things equal , depreciation of a country’s currency today lowers the expected domestic currency return on foreign currency deposits.

R$

Other things equal , appreciation of a country’s currency today raises the expected domestic currency return on foreign currency deposits.

>

<

= R€ + (Ee$/€/ E$/€ - 1)

R€ + (Ee$/€/ E$/€ - 1)=

How changes in E affect expected returns (III)

Figure 13-3 The Relation Between the Current E$/€ and the

Expected Dollar Return on Euro Deposits

Exceptedreturn oneuro return

2E 2$/€

1E 1$/€

3E 3$/€

Rates of return(in dollar terms)

Today's E $/€

With fixed Ee$/€ and

R€, the relation between today’s E$/€ and the expected dollar return on euro deposits defines a download-sloping schedule.

How changes in E affect expected returns (IV)

Given Ee$/€ and R€ ,

an appreciation of the dollar against the euro deposits, measured in terms of dollars, and vice versa.

Figure 13-3 The Relation Between the Current E$/€ and the

Expected Dollar Return on Euro Deposits

Exceptedreturn oneuro return

E 1$/€E 2$/€

Rates of return(in dollar terms)

Today's E $/€

E $/€

The Equilibrium Exchange Rate

Figure 13-4 Determination of the Equilibrium Dollar/EuroExchange Rate

Exceptedreturn oneuro return

2E 2$/€

R$

Return ondollar deposits

1E 1$/€

3E 3$/€

Rates of return(in dollar terms)

Exchange rate,

E $/€

R$= R€ + (Ee$/€- E$/€)/ E$/€

Equilibrium in the FX market is at point 1, where the expected dollar return on dollar and euro deposits are equal.

Interest Rates, Expectations & Equilibrium (I)

The Effect The Effect

of Changing of Changing Interest Rates Interest Rates on the Current on the Current Exchange RateExchange Rate

All else equal, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currency, and vice versa.

Figure 13-5 Effect of a Rise in the Dollar Interest Rate

Exceptedeuro return

R1$

1

R2$

Dollar return

1'E 1

$/€

E 2$/€

2

Rates of return(in dollar terms)

Exchange

rate,E $/€

R $

Conclusion:

The Effect of Changing Interest Rates on the Current Exchange Rate

All else equal, a rise in the foreign interest rate causes All else equal, a rise in the foreign interest rate causes the domestic currency to depreciate against the foreign the domestic currency to depreciate against the foreign currency, and vice versa.currency, and vice versa.

Interest Rates, Expectations & Equilibrium (II)

Conclusion:

18Figure 13-6 Effect of a rise in the Euro Interest Rate

Exceptedeuro return

1

2

E 1$/€

E 2$/€

Rates of return(in dollar terms)

Exchange rate

E $/€

R €

Rise in R€

Interest Rates, Expectations & Equilibrium (III)Figure 13-7 Effect of a rise in expected future exchange rate

Exceptedeuro return

1

2

E 1$/€

E 2$/€

Rates of return(in dollar terms)

Exchange rate

E $/€

E e $/€

The Effect of Changing expectations on the Current Exchange Rate

Conclusion: All else equal ,a rise in the expected future exchange rate causes a rise in the current exchange rate, and vice versa.

Interest Rates, Expectations & Equilibrium (IV)

1

Exceptedeuro return

E 2$/€

2E 1

$/€

Rates of return(in dollar terms)

Exchange rate

E $/€

Figure 13-7 Effect of a change in the dollar or euro Interest Rate

R €

R $

E e$/€

All else equal, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currency, and vice versa.

All else equal, a rise in the foreign interest rate causes All else equal, a rise in the foreign interest rate causes the domestic currency to depreciate against the foreign the domestic currency to depreciate against the foreign currency, and vice versa.currency, and vice versa.

All else equal ,a rise in the expected future exchange rate causes a rise in the current exchange rate, and vice versa.

Question

Thanks